Why China's rising tide isn't lifting emerging-market boats

China’s extensive list of monetary and fiscal stimulus measures is starting to produce an observable stabilizing effect on its economy. After over a year of disappointing Chinese economic data, first-quarter data has beat market expectations—the latest monthly Purchasing Managers’ Indexes reflect an economy that’s expanding marginally,¹ and most credit data appears to have troughed, in our view.

As a result, we’re cautiously optimistic on the Chinese growth story as we expect the economy to continue to stabilize; however, we’re not expecting a substantial v-shaped recovery like the one seen in 2015/2016.

Traditionally, an improvement in the China outlook implies important positive spillover effects to the global economy, particularly emerging markets in Asia. In our view, the emerging-market (EM) effects are likely to be more limited this time around, and with longer lags than what we’ve seen in the past. As a result, we think it’s important to temper optimism around the “it’s time to be bullish about EM Asia” thesis that’s been making the rounds.

By many measures, China’s current round of fiscal and monetary stimulus is as massive as what it had introduced in 2015/2016, yet its composition is substantially different. Over the past year, China’s fiscal stimulus has been predominantly focused on domestic consumption; for instance, authorities announced the country’s largest-ever personal income-tax cut, which has boosted middle-class incomes.² This is in stark contrast to previous rounds of stimulus that focused on the property sector—the most commodity-intensive sector—and infrastructure projects, which created demand for intermediary goods, commodities, and external goods.

While the current round of stimulus is certainly powerful enough to lift the Chinese economy, its domestic nature implies that it’s less likely to lead to a huge amount of international trade activities than we’ve witnessed in the past. Global trade is typically the default channel through which the Chinese recovery is filtered through to the rest of the world; without a sizable improvement in Chinese import volumes, China’s stabilization is likely to benefit its trading partners to a lesser degree.

Critically, heightened uncertainty over U.S.-China trade relations will almost certainly compound weak trade activity in the region, particularly in light of the fact that China’s consumption-targeted stimulus is likely to be more sensitive to confidence channels. It’s also possible that worsening trade negotiations could amplify the odds of additional stimulus from Beijing policymakers, but we believe any forthcoming measures are likely to be similar in nature to those that are already announced.

Despite expectations for a more muted impact, it’s still reasonable to assume that global trade volumes will improve marginally as China’s economy stabilizes. Even then, we don’t expect an immediate rebound in EM growth—several EM Asian economies, including Taiwan and South Korea, have elevated inventory levels that will have to be worked through before they can raise production.³ This wasn’t the case in 2015/2016, which in turn suggests a potentially longer lead time for real economic growth in EM Asia to rebound after trade channels have been reawakened.

In 2015/2016, several EM economies benefited from higher commodity prices following significant supply-side cuts from China’s heavy industry sectors (such as coal and steel), which included production and capacity cuts. These cuts resulted in higher capacity utilization rates that pushed the prices of these commodities higher and boosted profits in these sectors. This time around, however, the opposite occurred—the relaxation of some production cuts has kept key commodity prices relatively contained. As a result, economies in EM Asia that typically benefit from higher commodity prices may not get that much of a lift from China’s current stimulus, in our view.

Finally, the resilience of the U.S. dollar (USD) has become an additional headwind for EM Asian economies—their import costs rise as their currencies weaken against the greenback. We expect the USD to remain supported by better U.S. growth and heightened geopolitical risks over the next quarter, effectively placing a cap on growth in EM Asia.

1 Caixin China General Manufacturing Purchasing Manager Index, May 2019. 2 "This Is What China's Stimulus And Market Reforms Plan Looks Like," Forbes, 3/6/19. 3 Bloomberg, TD Securities, May 2019.